Reader Comment: RRSP vs. Mortgage

I’ve run many scenarios of RRSP vs mortgage over the years and have found the main determining factor is a huge surprise.

The top 3 factors in RRSP vs mortgage are:

1. How much of the mortgage payment will be invested once the mortgage is paid off?
2. Investment return vs. mortgage rate.
3. Tax considerations – tax-efficiency of investments and what you do with the RRSP tax refund.

Just ask yourself – once the mortgage is paid off, how much of the mortgage payment will I invest? If your answer is less than 90%, then RRSP is definitely preferable. Most scenarios require 100% of the mortgage payment to be invested before the mortgage strategy can compete with RRSP.

We have found that most people that prefer the RRSP are investors, while most that prefer the mortgage are really anti-debt people. We call this the “Sacred Cow”, which is very common in Canada. The belief is that we should pay off the mortgage and then we can spend much of the money and live a comfortable life without debt.

I often hear people telling me they can retire on almost nothing, since they will have no debt and they won’t be spending much money after they retire. We call this the “Zero Plan” for retirement.

However, when we go through the cash flow in detail and plan specifically what income they will need to have the retirement they want, their delusions are laid bare.

If you believe in the mortgage pay-down, ask yourself if you are really just anti-debt – and whether or not you will invest 100% of the mortgage payment once the mortgage is paid off.

The 2nd most important criteria is the investment return vs the mortgage rate. Considering that mortgage rates are around 5% and should stay low for nearly all of the next few decades (demographic reasons), it is not that hard to beat 5% after tax long term.

If you don’t know how to do this, email me.

Canadian Capitalist is right that the average investor makes returns far below average. In fact, the Dalbar study showed over 20 years, the average investor made only 3.5% while the investments they owned made 11%. How can this be? The human brain is conditioned to consistently market time badly. Read some behavioral finance and you’ll find it is hilarious.

In short, if part of your criteria for buying an investment is that it is currently “doing well”, you will almost definitely earn below average returns.

However, if you study investment philosophy and hire the world’s best investment managers to work for you – and don’t market time – then beating 5% after tax in the long run is a piece of cake.

The long run return of the markets is quite consistently 7% over inflation, based on “Stocks for the Long Run” (first book). There are fund managers that beat the markets over long periods of time – and can tell you why. Invest with a few of them and you’ll be fine.

By the way, a far better strategy is the Smith Manoeuvre. With the SM, you always do both at the same time – pay down the mortgage AND invest. Plus, since the SM requires none of your cash flow, you can still use your extra cash to either pay down the mortgage more – AND invest more, or invest in RRSP’s.

Paying down the mortgage AND investing is better than just paying down the mortgage OR investing, isn’t it?

Ed

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About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

It’s possible to combine the “invest now” approach with the “debt averse” approach. I do just that – I maximize my RRSP contributions, AND I pay extra toward my mortgage. This requires some sacrifices in terms of day-to-day cash flow, but in the long run I’ll have a sizeable nest egg AND a mortgage-free home when I retire.

The Smith Manoevre isn’t the only way to invest and pay down the mortgage at the same time. The above method does the same thing with less risk, but doesn’t have the advantage of tax deductions.

I’ll second George on that one. I pay down the mortgage and believe or not make rrsp contributions at the same time (I checked with the CRA & RCMP and this particular unnamed manoevre is indeed legal).

The two main problems I have with comparing rrsp paydown & debt reduction is that the extreme cases of only doing one or the other is not that common among people who have 2+ brains cells to rub together. The other problem is the conditions that Ed correctly mentions ie rrsp rebate must be reinvested, once mortgage is paid the same monthly amount has to be put into the rrsp etc are not consistent with real life. Even if you are 100% dedicated to pay down your mortgage then your annual payments are probably going to be all over the map. Another thing is that if you get your mortgage paid off, why would you automatically take that same amount of $$ and put it into investments? Once the mortgage is paid off, you should re-evaluate your situation and determine how much $$ should go into investments depending on your goals. This amount could be the same or different than the amount you were putting into the mortgage each year. And what about the mortgage rate assumptions? Since I’ve been a home owner (begin of 2000) I’ve had mortgages with rates of 6.7%, 3.1%, 3.8%, 5.65% and am looking to renew now for around 5%. Not to mention this covers two different houses with very different mortgage sizes. Lots of variance there.

Bottom line conclusion that I’ve come up with and I’ve seen in this blog as well as Cdn Capitalist (and probably many others as well) is that you can’t determine accurately enough which method will give you the best end result because there are too many assumptions about the future involved. Unfortunately the Smith Manoeuvre, however intriguing, is another scenario that can’t be evaluated properly because of the assumptions.

Having said that I’m not against the Smith Manoeuvre – if you are an investor & home owner and you feel it’s right for you then you have my blessings!

Some things to keep in mind though if you are evaluating the SM or even for normal retirement planning – the “Stocks for the Long Run” book is based on US stock data in the 20th century which was the most successful market in the world. Even on the assumption that future “long run” returns will equal those of the last century, that doesn’t mean that every investor’s timeline is long enough to qualify as the “long run” which will lower the probability that you will get close to the long run return. This doesn’t mean your actual return will be below the expected return – just not necessarily close to it.

Another thing to consider (and I’m not talking about Ed here), is that financial institutions and their agents will always come up with new products to try to make more money (that’s what businesses do). With the Smith Manoeuvre or leveraged investing then potentially that company can make money off both the lending side as well as the investment side so it’s in their best interest to market such ideas in a positive light.

Your point that doing both – maxing your RRSP’s and paying down the mortgage faster – is obviously better than either one. We get asked this kind of question every day, though, from clients that either can’t afford to do both or don’t want to take that much out of their cash flow.

So then we have a trade-off. To figure this out, we find that the 2 biggest issues are:

1. the portion of the mortgage payment that will be invested after paying down the mortgage.
2. how the RRSP tax refund is used.

These usually have at least as large an effect as comparing the mortgage and investment returns.

The U.S. stock market does have great long term returns, but they are only 1-2% higher than the MSCI World index. Most people are surprised to find that the long term stock market returns of most major countries are very similar!

There is always the question of how long is “long term”. The answer depends on how sure you want to be and what rate of return you need. But the period of time most people take to pay off their mortgage – 15-25 years – is long enough to qualify as long term.

We don’t really have the option to just say there are too many variables to consider. As financial advisors, we always have to make the best decision in our client’s long term plan. We know our investments very well and how they perform in good and bad markets, so the big variable of the investment returns is far more predictable for us.

The most significant issue, though, is that the main thing we do is help our clients get the retirement they want, which is usually similar to their existing lifestyle, less the mortgage and the kids, plus a bit of travel. To do this, assuming you can average 8% on your investments for life, most Canadians will need $1-1.5 million in financial investments to have enough to maintain their current lifestyle. We worked this out in detail for well over 1,000 families and most will need this much, and many will need far more.

For people that focus on the mortgage, how will they ever get the lifestyle they want in retirement?

Ed, I’m honestly rather shocked that you’re willing to push the “You’ll need over a million dollars to retire” line. The fact of the matter is that the vast majority of retirees do NOT have that kind of portfolio at retirement, and for some reason they seem to do just fine.

It’s easy to project outward by looking at the expenses of a family in their 20s or 30s, and determine that they’ll need a boatload of cash to maintain that lifestyle when they retire. Problem is, most people don’t have the same lifestyle when they retire, compared to when they were young adults.

Most retirees don’t have a desire to buy the latest electronic doodad as soon as it comes out. Most retirees don’t see the need to buy larger and larger houses, since they no longer have children staying at home. Et cetera.

If you haven’t already, I suggest you read “Why Swim with the Sharks”. It provides an excellent counter to the “you’ll need a million dollars to retire” argument.

Ed writes: “For people that focus on the mortgage, how will they ever get the lifestyle they want in retirement?”

I forgot to comment on this point. Here’s how:

I focus on paying down our mortgage. It’ll be paid off entirely by the time I’m 40. At the same time I’m maximizing my RRSP contributions, and I have a decent pension plan at work.

I’ve looked at the numbers, and by almost any account I’ll be able to retire at age 55 and receive 105% of my pre-retirement income. If anything, I’ll have a more lavish lifestyle in retirement than I will when working.

The main reason I’m able to do this is because we purchased a home that suited our needs but was not extravagant, and we’re paying it down somewhat aggressively (we put an extra $100 towards it every 2 weeks).

I’m not talking theoretically when I say, “You’ll need over a million dollars to retire” and maintain the same lifestyle as you have today. We’ve worked out in detail with thousands of families how much they will need, or how much they want.

I’m also talking about planning to have $1 million in 20-30 years, not people having $1 million now. With 3% inflation, the cost of living will double by then for most of us, so $1 million in 24 years will buy what $500,000 will buy today.

The fact that our parents are able to live “fine” on much less doesn’t mean our generation will. Most of our parents were born during the Depression and have always lived frugal lives without using credit. My parents did not have a sofa for the first 2 years of marriage until they could buy one for cash. This was the norm then, but I haven’t met even one family that did this in the last 30 years.

Us Baby Boomers are used to buying everything we want now on credit and have lived far higher standards of living than our parents did. We like to buy “reliable” cars, travel and renovate our homes regularly. Ask anyone you know to reduce their current lifestyle spending by $1,500/month. It’s easy to do if you put your mind to it, but there is a rare family these days that could do it. In our parents’ generation, nearly all lived at that level all their lives.

In your case, you are fortunate to have a decent pension, which very few people have, except for government employees. Is all your retirement income fully indexed?

If you do the math, when you are 65 and have $1,0000,000, if you can make 8% on your investments for life and you increase your income by 3% inflation each year, the amount you can withdraw for life (say 35 years) is $57,000year before tax. If you are now 40 and planning for retirement at age 65, this $57,000/year will buy what $27,000 will buy today.

In short, with relatively optimistic assumptions, $1 million in 25 years provides you $27,000/year in today’s dollars in indexed income when you retire. Add the CPP & OAS (if they will be there – OAS is in doubt) and your income is probably between $45-55,000/year before tax.

When we retire, a $1 million nest egg is a modest retirement.

I have not read the book you mentioned, but have read a similar one and several articles with similar themes. Is it worth reading? I find most like this are stories of “see how little money I can live on”, don’t fully account for inflation, or don’t include all the lifestyle expenses most of us are used to.

The good news is that accumulating $1 million is also much easier than most people think.

“My parents did not have a sofa for the first 2 years of marriage until they could buy one for cash. This was the norm then, but I haven’t met even one family that did this in the last 30 years.”

My wife and I started with a $25 sofa that we bought from friends of ours, followed by a cheap Ikea sofa that we’ve had for the past 7 years of our marriage. We’re just now planning on replacing it, because it’s wearing out. We plan on paying cash for a new one.

Your most telling statement is this: “Us Baby Boomers are used to buying everything we want now on credit and have lived far higher standards of living than our parents did.”

Here’s the problem: “Boomers” have lived a lifestyle that’s not sustainable. Your “higher” standard of living was premised upon spending more money than what was earned.

Try reading “Generation Debt” to get an idea of our perspective on the world. There’s a good reason that “Generation Y” is extremely bitter about the situation that’s been created for us by our parents.

My wife and I are extremely happy with what we have, and we typically only buy new things when the old ones wear out. We buy “reliable” cars that are a few years old instead of brand new ones. We don’t live like misers, but we are careful to focus our spending on things that are important to us instead of on the accumulation of endless amounts of consumable crap. When we want something, we save up for it instead of accumulating debt.

I think having an income of $45-55,000 a year in retirement is far larger than it needs to be. I’ve looked at my current spending, and if I eliminate expenses that I won’t have in retirement (daycare, mortgage payments, work-related expenses), and add in new expenses (more travel etc), our family income will need to be around $45k (today’s dollars). That amount will easily be covered by my pension, CPP, and OAS. My RRSP funds will be used to create an “early retirement” fund that I’ll draw upon in my early 50s.

Sure, I might not be pursuing the “boomer” lifestyle, and I might not have a million dollars to retire, but I’ll be happily retired at about age 50 (possibly earlier). I’ll have 15 more years than the average boomer to enjoy in retirement, and my spending patterns will ensure that my retirement will be sustainable until the day I die.

Mike: I agree that I’m generalizing when I refer to the “boomer” generation. Certainly there will be variations among any group. My background is sociology, so my focus tends to be on the “average” for a group. In the case of the boomers, it is true that one average they haven’t saved much for retirement and have spent vast amounts on credit.

This is part of the reason that many boomers, hitting their 40s and 50s, have started focusing on retirement planning over the past decade or so. They’ve realized that they’ve got some financial hurdles ahead of them, and they’ve turned to planners like Ed for solutions.

Getting told at age 40 (or, worse, 50) that you need a million dollars to retire, when you have less than $100k saved, is likely to be extremely disheartening. I think it makes more sense to look at your lifestyle as a whole, and to determine what’s worthwhile and what isn’t. In most cases, I think people will realize that buying “stuff” doesn’t make them happy.

I think it was described well in “Your Money or Your Life” when the authors identified financial happiness as having “enough, and a little bit extra”.

You don’t need 50k/year in retirement to have “enough plus a bit”, assuming your home is fully paid off and you have no other debts. Most retired people eat less food, live in cheaper accomodations, buy fewer big-ticket items (big TVs, cars, etc), and generally spend less money than they did when they were working. The reason for this, I think, isn’t a lack of cash but a lifestyle change that occurs with age.

I should also comment on Ed’s points re: inflation. Yes, inflation does affect people, but not as much as is hyped by financial planners. Inflation might be 3% from one year to the next, but that doesn’t mean that YOU are going to spend 3% more on what you buy. Inflation includes things like housing prices – unless you’re buying a new home every few years, rising prices won’t affect you that much. It also includes things that people have control over – if the prices of apples are inflated one week, you can buy oranges or bananas. Likewise, if the price of gas rises sharply, retired people have the option of not driving as much (they aren’t commuting), or driving a smaller car (they don’t need to haul a big family around). Inflation is something that should be factored into your plans, but it isn’t the menace that financial planners make it out to be.

I see you are both frugal people and would rather live on less and have fewer money worries. I am frugal as well and live far below the lifestyle I could afford. Your points do apply to people like us, since we could easily live on less. I agree that most people would benefit by living more frugally and focussing on more important things in life, instead of acquiring “stuff”, travelling, constantly renovating and buying new cars.

However, we’ve found that hardly any of our clients, and likely very few Canadians are like this. Few of our clients would be able to cut back their lifestyle by $1,000/month now, and they will be retiring on $2,500/month less than their current lifestyle (after allowing for having their mortgage paid off and kids expenses done) if they don’t invest a lot now.

You guys are definitely in the minority in Canada, but you are wise to have that outlook.

Retirees do live on less, but that is almost always because that is all the money they have. Hardly anyone wants to cut back their lifestyle. When they retire, they want to live the same and have a bit extra for more travelling or to enjoy some hobbies. But almost everybody that is retired has far less income than they had when they were working.

Your comment about inflation is also interesting. When I talk to seniors, many tell me that inflation is an average, but the things they spend money on go up more. They still have to buy groceries that seem to rise more than inflation, they still drive a lot, travel insurance sky-rockets, their medications are always expensive (until the government starts paying) and tradespeople are expensive to hire. Many have told me that inflation for them is much higher than 3%.

Ed writes: “Hardly anyone wants to cut back their lifestyle. When they retire, they want to live the same and have a bit extra for more travelling or to enjoy some hobbies. But almost everybody that is retired has far less income than they had when they were working.”

I think we agree on the above. Where we differ is that I think it’s quite possible to maintain a similar lifestyle upon retirement with a greatly-reduced gross income. Upon retirement, you no longer need to pay for many of the things that are paid for by working people – CPP, EI, retirement savings, pension contributions, a mortgage, child care, work clothing and commuting costs, et cetera. I think that a retirement income that is (gross) 50-60% of your pre-retirement income should be more than adequate to fund a happy, healthy retirement.

As to your comment about seniors thinking that their “personal” inflation rate is greater than 3%, I wonder how much of this is from actual measurement, and how much is simply a “gut feeling”. Sure, retirees still have to buy groceries, but they don’t need to feed hungry teenagers – they typically are just buying food for two people.

If the costs of driving and travel insurance skyrocket, retirees can always cut down on their travelling – working people typically don’t have such an easy option (because most of their travel expenses are tied to their daily commute). Retirees, if they plan carefully, should be able to dodge inflationary pressures much better than the average worker.

George,
I disagree with your comment about inflation in the following fashion: once the retiree has built their budget, the inflationary spiral hits them as it does any one else. That they no longer have hungry teenagers has already been accounted. On the other hand, I agree that additional travel, travel insurance, etc., and other additional expenses are choices, and the retiree has many options, not all are equally applicable.

In my personal instance, other than employment deductions (CPP, EI, Pension) my living costs in retirement will not be much reduced. Having my mortgage paid will be the greatest savings, yet it is one of the anti-inflationary payments I have, as it continues to be paid in 2003 dollars. My situation is in large part due to current job & lifestyle choices I have made. My work dress is casual (pants & open collar shirt), my 20 minute commute costs a pair of shoes (or two) annually. We are already making moves to reduce our house costs, by installing a heat pump, fluorescent lighting, and other such steps. However, any inflationary increase to the baseline costs of running the house will be felt. A further savings might be the development & use of a basement apartment which we would move into, renting the rest of the house to someone needing more space!
We can save in transportation by choosing a more fuel efficient vehicle – we currently own a mid-size pickup truck to tow our small trailer. However that would mean a change in our vacation style.

I still have trouble accepting the ‘million dollars for retirement’ promoted by many, however, I could only see reducing my take-home pay by the cost of my mortgage, were I to have a satisfactory retirement. If so, I’d still need a buffer to allow for the inflationary costs in those future years.